Straddle

In finance, a straddle is an investment strategy involving the purchase or sale of particular option derivatives that allows the holder to profit based on how much the price of the underlying security moves, regardless of the direction of price movement. The purchase of particular option derivatives is known as a long straddle, while the sale of the option derivatives is known as a short straddle.

Long straddle

A long straddle involves going long, i.e., purchasing, both a call option and a put option on some stock, interest rate, index or other underlying. The two options are bought at the same strike price and expire at the same time. The owner of a long straddle makes a profit if the underlying price moves a long way from the strike price, either above or below. Thus, an investor may take a long straddle position if he thinks the market is highly volatile, but does not know in which direction it is going to move. This position is a limited risk, since the most a purchaser may lose is the cost of both options. At the same time, there is unlimited profit potential.

For example, company XYZ is set to release its quarterly financial results in two weeks. A trader believes that the release of these results will cause a large movement in the price of XYZ's stock, but does not know whether the price will go up or down. He can enter into a long straddle, where he gets a profit no matter which way the price of XYZ stock moves, if the price changes enough either way. If the price goes up enough, he uses the call option and ignores the put option. If the price goes down, he uses the put option and ignores the call option. If the price does not change enough, he loses money, up to the total amount paid for the two options. The risk is limited by the total premium paid for the options, as opposed to the short straddle where the risk is virtually unlimited.

Short straddle

A short straddle is a non-directional options trading strategy that involves simultaneously selling a put and a call of the same underlying security, strike price and expiration date. The profit is limited to the premiums of the put and call, but it is risky because if the underlying security's price goes very high up or very low down, the potential losses are virtually unlimited. The deal breaks even if the intrinsic value of the put or the call equals the sum of the premiums of the put and call. This strategy is called "nondirectional" because the short straddle profits when the underlying security changes little in price before the expiration of the straddle. The short straddle can also be classified as a credit spread because the sale of the short straddle results in a credit of the premiums of the put and call.

A short straddle position is highly risky, because the potential loss is unlimited due to the sale of the call and the put options which expose the investor to unlimited losses (on the call) or losses equal to the strike price (on the put), whereas profitability is limited to the premium gained by the initial sale of the options. The Collar is a more conservative "opposite" that limits gains and losses.

Straddle at-the-money

Technically, if you are buying a call and a put at the same price, you are buying a straddle. However, in practice it is usual to buy a call and a put that are approximately at-the-money. This is because if, say, the stock price is 85 and you are buying a straddle at 50, what you get is essentially a long position in the stock, so you are not really betting on volatility.

Delta-hedging a straddle

A straddle that is approximately at the money has delta that is close to zero. However, if the stock price moves substantially up or down, then a straddle essentially becomes a short or a long position in the underlying (stock). If the stock went up, then the side that is long the straddle would now prefer the stock to go higher up (so it is essentially long the stock), while the side that is short the straddle would now prefer the stock to go back down (so it is essentially short the stock). For a straddle at-the-money it does not matter so much whether the stock goes up or down, the only question is how far. However, when the put of the straddle is deep out-the-money and the call of the straddle is deep in-the-money (or vice versa), both sides (long and short the straddle) have a marked direction preference. Therefore, delta-hedging can be used.

Nick Leeson and the Barings Bank collapse

Nick Leeson took short straddle positions when chasing losses he had run up for his employer, Barings Bank. He had initially dealt in futures on the Nikkei 225 stock index. Following a dramatic fall in the market, largely due to the Kobe earthquake, Leeson lost millions. He tried to re-coup these losses by dealing in the higher risk, but potentially more rewarding, straddles. He bet that the Nikkei would stabilise and stay in a range around 19,000. His bet failed and losses escalated to $1.4bn, causing the bankruptcy of Barings.

References

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External links

Option Straddles Numerical example of using straddles.

Option Trading Straddles Delta Neutral Strategies.

Category:Options